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Wednesday, August 31, 2016

Trade Ideas: Macro Trades - The Fall-Winter Collection

The speech from Fed Chair in the Jackson hole was quite uneventful. The far more interesting was this one. It was a while back the ever useful Michael Pettis hinted at how rate cuts can be deflationary - exactly the opposite of mainstream central bank thought process. This represents another argument, and how crucial fiscal participation is in delivering monetary objectives.

Talking of central banks, this month is another one for central bank focus. Starting with ECB next week, followed by BoE around middle of the month, and ending with Fed and BoJ towards the end, the mood of the market is expected to swing based on these policy outcomes. The general expectation is a hawkish Fed while the rest continues the dovish stance. Here are the top 5 trade to consider for the moment.

#1: Pay USD 10y swap spread: USD swap spread was hammered just after the last FOMC hike in December, but now on a slow yet firm upward trend. Theoretically, swap spread should be determined by the expected futures spread on GC rate vs libors. While empirically this had little influence for US treasury swap spreads in the past, still this is an important metrics. And if you have not been gone for long for the summers, it is hard to miss the sharp widening of the spot spread of GC vs libor - mainly influenced by the sharp increase in libor rate. There is a good reason for this, as the market regulations kicking in forced quite a few prime money market funds from bank-issued commercial papers to US treasuries, pushing up the borrowing cost for the banks. It appears so far this yet has to be passed through the swap spread prices in any form or substance. On top, a pay position in swap spread (pay swap, receive treasury) has been highly directional with general rates levels historically. Given this correlation and the current levels (near the bottom of the trend channel), this represents an efficient position for any FOMC hawkishness, especially unexpected ones. This also benefits from a positive roll-down. In addition, this position is empirically should be somewhat long volatility - quite an asymmetric position at current levels.

#2: Pay GBP 10s30s steepener: Following Brexit, the long end sterling curve steepened sharply, followed by an equally sharp flattening after the early August BoE. This is presumably a reaction from the QE announcement, but it is not entirely intuitive. While we had similar sharp flattening move in Euro after ECB QE in early 2015, the large difference in size between this two perhaps points towards a bit over-reaction (ECB's initial €60b per month, later €80b, compared to BoE's £10b per month, i.e. £60b over 6 months). Not only in terms of absolute size, the ECB QE is also larger in comparison with the supply - for example at the ECB capital key, Germany amounts to approx €20b per month currently, compared to a gross supply of around €16b per month (as per Bundesbank projection figures for this years). For the UK, this compares to £10b per monthly to £11b of monthly supply (as per UK DMO projections). This does not correct for the German securities trading at an yield lower than ECB depo rate (and hence not eligible for QE), and also the fact that ECB QE will extend beyond the BoE one, hence the actual difference in supply pressure is much more acute. The second interesting point to note is the maturity distribution (see chart below). UK has a squeeze in the middle segment (belly, i.e. 7 year to 15 year remaining maturities) of the curve, whereas the squeeze for ECB is mostly in the long end, putting a relative rally pressure in the belly UK Gilts curve. Add to this the facts that the market price of expected inflation spread between UK and Euro area (breakeven inflation swap) has actually widened following Brexit. This is presumably influenced by the sharp decline in GBP vs USD, but this inflation premium somehow has to be priced in the nominal rates which in general should exert a steepening pressure. This combination makes a steepening position for GBP 10s30s attractive. One of the possible reason for such a sharp flattening can be the expressed intention of the BoE governor to steer clear of negative rates and that remains a risk (somewhat mitigated by a still 25bps to go). Other risk is a sudden strong recovery in UK economy, which will weaken the case for steepening.

#3: Equity bearish protection: For all those bears out there, shorting the all time highs have been as appealing as it has been money loosing since June. The equity markets around the world has been quite oblivious to shocks. FTSE 100 had one of the best runs in Europe. European equities have been less spectacular, but nonetheless not in correction territory. Nikkei 225 handled strengthening yen better than expected. Even EM had a decent run. The key has been the amazing resilience of S&P 500 - and appears everything is now pending on a breakdown in the US equity market. As a result, S&P is now trading at tad lower from all time high, and tad higher than all time low realized volatility. On top, last print from CFTC traders positioning shows the highest ever short positioning in VIX. But there are potential issues on the horizon to be cautious, FOMC in September is the obvious one, South African political situation may be a trigger, or sometimes things just happen. Fortunately, we also have the S&P calendar vol spreads around the highs. This present a good cautious positioning of buying the near term puts vs long term (e.g. 3m/6m) - relatively less damning long gamma position. A large downside move in the US equity market will almost certainly have repercussion across the globe, and if triggered by FOMC, especially across the emerging markets.

#4: Pay Cross-currency basis widener in EUR: One for the long-ish term - this is a reversal of Euro savingsglut trade. Since the start of the financial crisis, the cross currency basis widened as everyone panicked after dollar funding. Subsequently during the period of European sovereign crisis, this basis remained under stress, and only started normalizing after the whatever it takes promise from ECB's Draghi. However, after peaking at around mid 2014, this basis (not only in Euro, but across major currencies like GBP and JPY), started widening again. My theory is: this time it has less to do with financial market panic and shortage of dollar funding from the liability side, and more with the savings glut on the asset side. In such a scenario, asset managers willing to invest in higher yielding assets (like US treasuries or equities) will swap their euro funding with a euro vs dollar cross currency swap (effectively a dollar loan against euro) and paying dollar interest vs receiving euro interest. As more and more money chase this trade, there will be a receiving pressure on the euro leg, pushing the basis down. The fact that this is asset driven and not liability driven is corroborated by a flattish slope in the basis for different maturities. During the panic days, it was a strictly inverted slope (e.g. 1y tenor wider than 5y), which is now reversed or almost flat. Given this, any recovery in the euro area (and indeed globally) consumer and investment spending will set the direction in a reverse trend. Currently the levels are near short term support. Also given the slope as mentioned above, this benefits from a positive roll-down. This is a relatively low risk and low cost of carry trade for global economic recovery. The alternative is of course that long-dated forward trade in euro. But I like this one better at the moment: the long dated forward can remain stuck even after normalization (i.e. end of savings glut), but the basis will surely feel the pressure. Plus the once juicy carry in those long-dated forwards are mostly gone. Reportedly, there is currently a dollar funding shortage, on account of the money market regulation change mentioned above. But also reportedly a large part of the switch from CP to treasury is done.

#5: The ECB Trade: ECB is not BoJ and Euro area is not yet Japan. The question is if you see them converging or diverging. The chart below shows market reactions in rates and FX for recent major central bank decisions in Euro area and Japan. Note how in recent time, ECB meetings followed a rally in Euro and a flattening in the curve. Also note how the similar the reaction was in BoJ. And finally, how the last one from BoJ in July end, which underwhelmed the market, reversed the flattening trend, with less pronounced effect and in fact a net steepening. The story of QE is perhaps running out of steam.

I expect similar reaction for ECB even if they announce a QE extension beyond September 2017. The standard trade will be fading the move, which is as of today expected to be a steepener. However, a rally in Euro may be more difficult in the short term as the focus shifts immediately to Fed.